Minimize Your Income Tax Liability
The goal of income tax planning is to help minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you’d look at ways to help reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to help lower your overall income tax burden.
Postpone your income to help minimize your current income tax liability
By deferring (postponing) income to a later year, you may be able to help minimize your current income tax liability and invest the money that you’d otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.
Certain retirement plans can help you postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary to the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax-deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax-planning options.
Shift Income to Your Family Members to Help Lower the Overall Family Tax Burden
You can also help minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you’ve made the gift, the dividends will represent income to them rather than to you. This may help lower your tax burden. Keep in mind that you can make a tax-free gift of up to $13,000 per year per recipient without incurring a federal gift tax.
Under these rules, for children (1) under age 18 at the end of the tax year, (2) between ages 18 and 19 at the end of the tax year whose earned income didn’t exceed one-half of their own support for the year (excluding scholarships), or (3) full-time students between ages 19 and 24 at the end of the tax year whose earned income didn’t exceed one-half of their own financial support (excluding scholarships), any unearned income over $2,100 is taxed at the parent’s marginal tax rate.
Also, be sure to check the laws of your state before giving securities to minors. Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.
Deduction Planning Involves Proper Timing and Control Over Your Income
Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.
As a starting point, you’ll have to decide whether to itemize your deductions or take the standard deduction. Generally, you’ll choose whichever method lowers your taxes the most. If you itemize, be aware that some of your deductions may be disallowed if your adjusted gross income (AGI) reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI. To lower your AGI for the year, you can defer part of your income to the next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.
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